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September 24, 2012

Will Australian Financial Reforms Be a Template for the U.S.? Pt. 2

Changes include a ban on investment commissions and fiduciary duty for those giving advice

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Looking at how the financial advice marketplace has grown in the U.S., particularly over the past two decades, provides a great deal of insight about how the set of new financial regulatory reforms, called the Future of Financial Advice, may play out in Australia.

One of the most notable distinctions between the current U.S. and Australian marketplaces is the dearth of independent firms in Australia. To some extent, this appears to be due to licensing requirements that make it significantly harder for one to "simply hang a shingle and open for business" in Australia than in the U.S. At the same time, though, I suspect that much of the difference has to do with what is still a relatively heavy focus on commissions for at least some part of advisory business revenue, which in turn limits how large advisory firms grow, and how much they're willing to take the risks of going independent and building out their own staff and infrastructure.

By contrast, the U.S. firms that have grown on a recurring revenue basis, with far greater revenue and profit stability, have driven much of the independent movement, making the space lucrative enough for new businesses to emerge that support the independent industry, and in turn allow it to be profitable for an ever-wider range of independent firms.

This progression in the U.S. has become an ongoing challenge for the broker-dealer community, arguably exacerbated for many of the largest wirehouses due to tarnished brands after the 2008 financial crisis. But even without the 2008 crisis, broker-dealers have already been struggling with ever-more-compressed profit margins, as the firms struggle to justify their infrastructure costs and the segment of revenue they keep from their representatives. Increasingly, firms are "doing the math" and realizing that at a certain size, it's simply more profitable to go independent and, through a combination of hiring and outsourcing, replace the key services the broker-dealer previously provided.

While the growth of recurring fee (AUM) models emerged slowly in the U.S., the FOFA reforms will force the evolution to occur rapidly and suddenly in Australia. Initially, I suspect that many advisors in Australia will be inclined to cling to their dealer groups through the transition, seeking guidance and insight from the parent company about how to transition their business models effectively, and implement new systems and processes to meet everything from the new fiduciary requirement to the new business model itself.

Although FOFA does allow any form of fee arrangements, I strongly suspect that most advisors will migrate quickly to an AUM model, rather than a retainer fee or hourly model, both because it is likely more familiar to the advisor, and because I suspect that in Australia the typical retail client is even less accustomed to the saliency of retainer and hourly models than they are here in the U.S.

The next change in the Australian marketplace is likely to be driven by the dealer groups. In the near term, FOFA may be an effective test of the role that commissions really did play in advisor recommendations—will investment activity decline without commission incentives? And if so, what will that do to the profit margins and health of the dealer groups? Perhaps more significant, though, is the question of what such a shift may do to the dynamic between dealer groups and their advisors.

After all, my impression is that one notable difference between the U.S. and Australian marketplace is the relative dearth of direct-to-consumer options for Australian investors. Firms like Charles Schwab, ETrade, Scottrade, TD Ameritrade, etc., do not have a comparable presence down under. Which means it's entirely possible that some dealer groups decide the best way to continue distributing their financial services products may be to skip the no-longer-incentivized advisors altogether, and go directly to the consumer! I wonder if we won't see the Australian Securities and Investments Commission (ASIC) struggling in a few years to rein in aggressive direct consumer financial products advertising?

Once the initial shock of the transition has worn off, I suspect the real challenge in the Australian marketplace will be for the dealer groups to continue to justify their value proposition—carrying their "old" infrastructure and legacy—to advisors that are now growing almost exclusively AUM-fee practices. This will create tremendous opportunities in the Australian marketplace, especially for third-party providers to serve advisors that want to transition away from dealer groups—everything from portfolio management software to client relationship management software to trading platforms to independent custodians.

In the U.S., the independent support infrastructure has grown slowly and taken years to gain momentum in drawing advisors away from the broker-dealer environment. In Australia, as the transition to the AUM model is accelerated, it may also accelerate an explosion of providers seeking to draw advisors away from dealer groups to a simpler, more efficient, more profitable business structure.

Australian Reform Implications for the U.S. Marketplace

Notwithstanding what Australia might learn from how recurring fee business models have changed the advisory landscape here in the U.S., I suspect that in the coming years there will also be a great deal that the U.S. financial advisory world can learn in seeing the regulatory reforms play out in Australia.

Just a few interesting questions to examine in the next few years will include:

Will advisors be able to adapt to the new reforms and adopt viable business models? Or will there be attrition in the number of advisors in Australia?

Will consumers be willing to adapt to the new advisor business models? Will investors tolerate a more salient pricing structure from advisors, or turn to direct-to-consumer alternatives to meet their needs?

Will Australian advisors be able to create "scaled advice" (i.e., modular planning) businesses, such as the Garrett Planning Network here in the U.S., to serve less affluent consumers? Or will the elimination of commissions reduce access for the less affluent to financial advisors (which some groups have suggested may occur with a fiduciary duty here in the U.S.)?

Will a fiduciary duty change advisor behavior? How will the fiduciary duty be overseen and regulated? Will the fiduciary duty be a moot point in light of the ban on commissions, or will ASIC find additional oversight concerns for noncommissioned fiduciary advisors?

Will FOFA create an accelerated independent trend in Australia, or will the ban on commissions successfully force dealer groups to reform their own infrastructure to retain and serve advisors in a cost effective manner? Will dealer groups in Australia provide a template for US broker-dealers about what "life beyond commissions" can look like, or will the ban on commissions prove that broker-dealers are not financially viable without high-margin financial products to distribute?

Will some dealer groups decide that it's more profitable to go directly to consumers and skip working with advisors no longer incentivized to sell products, rather than retool their businesses to serve AUM-based advisors?

Will segments of the financial services industry find loopholes in the FOFA reforms? Will we gain any insights about how to implement and oversee a uniform fiduciary duty in the US based on whatever struggles emerge as ASIC tries to oversee the fiduciary duty for Australian advisors?

In one regard, the fact that such financial reforms are happening in many other developed financial services markets before the U.S. suggests that the United States has fallen behind in the evolution of regulating financial advisors. On the other hand, the fact that reforms are moving forward first in Australia and the U.K. may provide a revealing glimpse of the consequences, both expected and unintended, that result from the application of a ban on commissions and a fiduciary duty for advisors.

Notably, Section 913 of Dodd-Frank is driving the U.S. toward a uniform fiduciary standard for advisors, but unlike Australia and the U.K., the proposed reforms would not ban commissions but merely subject recommendations to a fiduciary standard (regardless of how implementation is compensated). Will the results in Australia and the U.K. reveal that that is the wrong approach, or show that it may actually be a better way to ensure a wide range of consumers are served?

So what do you think? What insights from the U.S. marketplace do you think will apply as Australia (and the U.K.) implement their advisor fiduciary duty and a ban on investment commissions? Do you think there will be unintended consequences? What lessons would you hope to learn from the U.S. perspective to inform future regulation here?